Co-CIO, President, and Portfolio Manager Chuck Royce discusses his outlook on the current state of the small-cap market, his continued confidence in quality despite the Fed’s announcement in September to prolong its ongoing stimulus efforts, and the current case for active small-cap management.

With such a strong rally for the Russell 2000 Index through the end of September, what is the state of the small-cap market right now? What is your outlook?It seems to me that there are two parts to this: Small-caps have been on an extraordinary run since the trough in 2009—from the March 9 low in that year through the end of this year’s third quarter, the Russell 2000 advanced 233.2%, which is an outstanding performance over a more than four-year period. As a result of this bull phase, the three-year average annual return for the small-cap index is approaching the stratosphere.

Year-to-date through September 30, 2013, the Russell was up 27.7%, which was also remarkable. Since the inception of the index at the end of 1978, small-caps exceeded that nine-month return 56 out of 409 times when you measure using monthly rolling returns.

So this is an extraordinary time in the literal sense of the term. It seems unlikely to me that small-caps can keep up the current pace. History certainly indicates that they won’t.

So while I expect returns to level off over the next couple of years, I also still see positive results for small-caps. The economy is growing, however slowly, many investors remain very under-invested in equities relative to bonds, and I expect a number of opportunities within the small-cap space can continue to bear fruit over the next few years.

If the economy keeps growing slowly, isn’t the market likely to see a major correction?

Many market observers have been noting that stocks are ahead of fundamentals, and I see some truth in that. But I don’t think this means that small-caps are on a collision course with a sustained decline or a catastrophic correction such as we saw in late 2008-early 2009.

I think we’re more likely to see a series of small corrections that will slow the current breakneck pace of returns. It seems to me that this is all part of a larger normalization process affecting the economy and the financial markets.

Corrections are a fact of life, and we haven’t seen one in a while. So there will be some pullback, but I believe it will be manageable, at least for those of us with a disciplined, long-term approach.

Are you concerned that quality will continue to lag now that the Fed has announced it will not initiate tapering any time soon?

Not really. I think that since May of this year, we’ve seen the market begin to reward quality. Several of what we see as our highest-quality names have done well during this time, while many income-at-any-price investments, such as REITs, have fallen back.

High-growth, more speculative issues have also done well so far this year, even better than in 2012, but I suspect that quality stocks, which we define primarily as those with strong balance sheets and high returns on invested capital, will continue to emerge.

In our view they remain one of the few reasonably, or in many cases attractively, priced areas in the small-cap market. We see more and more investors catching on to their appeal.

Do you think the Fed is sending a mixed message to investors?

I think it’s certainly been a confusing message, which was arguably more confusing for bondholders than investors in equities. It was very interesting to me that rates fell only slightly in mid-September when the Fed announced that tapering would be delayed for a while. The rate on the 10-year Treasury did not come close to where it was in May.

I think this small decline is a healthy sign. In one sense, bondholders simply did not believe the Fed. In fact, I think most investors throughout the market are acknowledging that tapering has to start soon, that rates need to keep rising incrementally, and that the economy is healthy enough to stand more firmly on its own feet. And even with the recent increase, it’s important to remember that on an absolute level, interest rates are still quite low.

Yet I think the effects of that policy are played out. So I see the potential for success for active management approaches that emphasize quality and that seek the best-run, most fundamentally sound companies, which are ultimately the best businesses in that they have the ability to compound over long-term periods.

This gives them the potential to provide the returns most investors want, whether it be in the form of dividends, share buy-backs, or other prudent and sensible methods of allocating capital.

Those are the companies we’re looking to invest in every day.

Important Disclosure Information

Chuck Royce is President, Co-Chief Investment Officer, and a portfolio manager of Royce & Associates, LLC, investment adviser for The Royce Funds. Mr. Royce's thoughts in this interview concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

The Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. Russell 2000 Index is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index.

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